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What Did We Learn from the Financial Crisis, the Great Recession, and the Pathetic Recovery?

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What Did We Learn from the Financial Crisis, the Great Recession, and the Pathetic Recovery? What Did We Learn from the Financial Crisis, the Great Recession, and the Pathetic Recovery? by Alan S. Blinder, Princeton University Griswold Center for Economic Policy Studies Working Paper No. 243, November 2014 This paper is based on a presentation at The Fourth Annual AEA Conference on Teaching and Research in Economic Education, Washington, DC, on May 30, 2014. This paper comes in three parts. Part 1 reviews a few pertinent facts about the stunning economic events that have occurred in the United States (and elsewhere) since 2007. I choose these particular facts from among many for their relevance to the rest of the paper. The next two parts take up, first, some of the key lessons that we professional economists should have learned from the crisis and its aftermath and, second, some important lessons for teaching economics--especially but not exclusively macroeconomics. The two categories of lessons overlap a bit. But is it perhaps surprising how different they are. 1. A few pertinent facts The Great Recession that began, according to NBER dating,1 in the final month of 2007 was the worst in this nation’s history since the 1930s.2 The peak-to-trough decline in real GDP was 4¼ percent, compared to less than 2½ percent for the deep 1981-1982 recession. The corresponding peak-to-trough decline in payroll employment was even larger: a heart-rending 6.3 percent, versus just 3.1 percent in 1981-1982. Furthermore, in sharp contrast to the notion that severe recessions are followed by sharp recoveries, the recovery that started in mid-2009 has been one of the most anemic on record, with an average compound growth rate (through 2014:3) of just 2.2 percent. It wasn’t until 2011:2 that real GDP returned to its 2007:4 level, and it wasn’t until May 2014 (the month of the AEA conference) that payroll employment re-attained its January 2008 peak. At the time of the conference, the CBO was estimating a GDP gap of 4.5 percent of real GDP in 2013. All in all, it’s been a miserable performance. But it would have been much worse had Congress, the US Treasury, and the Federal Reserve not taken a series of extraordinary actions.3 After much prodding and a Munchian scream from the stock market in 2008, Congress held its collective nose and passed the much-reviled Troubled Assets Relief 1 I prefer to date this recession from September 15, 2008, the day Lehman Brothers filed for bankruptcy protection. But I’m not a bureau. 2 Official quarterly GDP data are not available for the 1930s, but from what we know, the 1937-1938 recession was far worse than the 2007-2009 recession. The latest recession is noticeably worse than any other post-World War II recession. 3 Mark Zandi and I (2010) estimated that, without these actions, real GDP in 2011 would have been $1.8 trillion lower and the unemployment rate would have been 6.5 points higher. 2 Program (TARP), which was quickly labeled a “$700 billion bank bailout” although it was neither.4 Months later, under the Obama administration, Congress passed a huge fiscal stimulus over almost unanimous Republican opposition. The Federal Reserve put a lot of taxpayer money on the line to rescue Bear Stearns and AIG (but not Lehman Brothers). It created an alphabet soup of lending facilities to extend credit to banks and nonbanks alike in ways previously thought unimaginable—and to bring the moribund markets for commercial paper and mortgage-backed securities back to life. It expanded its balance sheet from under $1 trillion to about $4.5 trillion through a variety of programs known as “quantitative easing” (QE). And it led innovative, multi-agency “stress tests” of the nation’s largest (and, in a few cases, shakiest) financial institutions in the spring of 2009. The Treasury put Fannie Mae and Freddie Mac into conservatorship, lobbied for and administered the TARP and the GM and Chrysler bailouts, creatively (also legally?) used the Exchange Stabilization Fund to guarantee assets in money market mutual funds (which were experiencing runs), announced the bank stress tests, and more.5 The FDIC took the amazing step of guaranteeing certain long-term non- deposit liabilities of banks and nonbanks. This flurry of activity constituted the most interventionist set of economic policies in the U.S. since mobilization for total war in the 1940s. And it worked. There was no Great Depression 2.0; we did not have to nationalize the banks; once the dust settled, the government turned a sizable profit on its rescue operations.6 Yet here is what I call the policy paradox:7 Most if not all of these policies, though successful, have been vilified; they helped create an anti-government backlash with which we are still living. 4 Outstandings under TARP never topped about $425 billion, and the bank “bailout” consisted of loans that were and stock purchases of stock that turned a profit. 5 One example: the mostly-unsuccessful and, I would argue, half-hearted attempts to reduce home mortgage foreclosures. 6 It is frequently objected that this profit calculation is bogus because an actuarial cost should be recorded for possible losses to taxpayers. That’s true, and CBO scored TARP that way originally. A January 2009 CBO estimate placed the average subsidy value at 26% of the (early) outlays. See CBO (2009). But the actions themselves prevented losses from occurring—or at least reduced the odds severely. Besides, had substantial taxpayer money been lost, do you think anyone would be arguing that we should count only the actuarial expectation of loss? 7 See Blinder (2013), especially Chapter 13. 3 An anti-government backlash? Yes, but it was more particularly a backlash against the Democratic Party. Once Barack Obama became president, Republicans opposed virtually every anti-recession measure, attacked the Fed, and called for fiscal austerity. Then they swept to impressive electoral victories in the 2010 and 2014 midterm elections. (In between, President Obama somehow won reelection.) The Tea Party, in particular, had its origins in the famous “Rick Santelli rant” against the Obama administration’s (weak) foreclosure mitigation program. The hated TARP, which was suggested by and passed under President George W. Bush, became, in the public eye, an Obama policy.8 One piece of this backlash was directed at Keynesian economics—not at any of the fancy stuff, but at the most elementary ideas. Keynesian teaching in textbooks since the 1940s has held that both monetary stimulus (lower interest rates, more money creation) and fiscal stimulus (tax cuts, government spending) can mitigate recessions. Many Keynesian economists, including me, go on to the normative position that central banks and governments should use monetary and fiscal policies for this purpose. And in this particular mega-recession, countries all over the world did stimulate their economies, to good effect. Focusing on the United States, Congress enacted a modest-sized tax cut (about 1 percent of GDP) in 2008 and a massive stimulus package (about 5 percent of GDP) early in 2009. Roughly a third of that package was tax cuts. Some true Keynesians, such as my colleague Paul Krugman, criticized the 2009 stimulus as inadequate. But it was large by any historical standard.9 Because of the stimulus and the huge recession, the federal fiscal deficit rocketed to about 10 percent of GDP—a shockingly large number for the USA. And largely because of that huge deficit, a severe political backlash against “deficit spending” (but perhaps not against tax cuts) developed and, more or less, took over the fiscal policy debate in the U.S.—which by 2010 was focused on reducing the deficit. By 2013, the fiscal drag was extreme, perhaps in the range of 2 percentage points of GDP growth. 8 For example, a Pew (2010) poll in 2010 found that only 34% of Americans (34%) said the TARP was enacted under President Bush administration; 47% said it was passed under President Obama. 9 Krugman’s point is that the need was huge. The stimulus was not large enough to fill the entire GDP gap. 4 The Fed, for its part, pulled out all the stops. After some initial hesitancy, it dropped the federal funds rate to near zero by December 2008 and then turned to a variety of “unconventional” monetary policies like massive lending, quantitative easing, and explicit forward guidance. As noted, the size of the Fed’s balance sheet rose by about a factor of five. Even more stunningly, banks’ holdings of excess reserves—which, textbooks teach, are normally zero—skyrocketed from about zero when Lehman failed to about $800 billion soon thereafter and eventually to an astounding $2.6 trillion. As all this was happening, critics began warning—even while the crisis was still white hot—that such hyper-expansionary monetary policies sowed the seeds of future inflation. Some of the criticisms reflected abysmal ignorance. For example, strident objectors to “big government” seemed just to discover that the Fed had enormous discretionary power to “create money”--and they didn’t like that. But other criticisms, such as those from Allan Meltzer (2009) and John Taylor (2009), hardly reflected ignorance. These and other experts urged the Fed to cease and desist from its extraordinary efforts to fight the Great Recession. All of this adds up to a very big deal--indeed, to several very big deals: earth-shattering economic events, stupendously large and sometimes innovative policy responses, and a severe backlash that altered the US political landscape for years to come. Hmm. Sounds a bit like the Great Depression and the New Deal.
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